A covered call is an options strategy in which an investor holds a long position in an asset (typically shares of stock) and sells (or “writes”) call options on that same asset. The goal of this strategy is to generate additional income from the options premium, while potentially allowing for capital appreciation on the underlying asset. Let’s break down how it works and its potential implications:
How Covered Call Strategies Work:
- Underlying Position: Before selling a call option, you should own the underlying asset. If you sell a call option for 100 shares, you should own at least 100 shares of the stock in question.
- Selling the Call Option: After owning the shares, you sell call options against them. By doing this, you receive the premium—the price the buyer pays you for the right to possibly buy the stock from you later at a predetermined price (the strike price).
- Underlying asset stays below the strike price: If, by expiration, the stock price remains below the strike price, the call option will expire worthless, and you keep the premium. You still own the underlying asset and can choose to sell another call option against it.
- Underlying asset exceeds the strike price: If the stock price rises above the strike price, the call option might be exercised. You would have to sell your shares at the agreed-upon strike price. However, you keep the premium and any gains up to the strike price.
Who May Want to Use Covered Calls:
- Income Seekers: Investors looking for an additional income stream from their stock holdings may find covered calls appealing due to the option premiums.
- Conservative Investors: Those with a neutral to slightly bullish outlook on a stock might use this strategy. They believe the stock won’t rise significantly in the short term and are willing to limit potential upside for immediate premium income.
- Stock Owners Willing to Sell: If you’re okay with potentially selling your shares at a specific price (the strike price), then a covered call can be a way to earn some income while waiting to sell.
Who May Want to Avoid Covered Calls:
- Very Bullish Investors: If you believe the stock will skyrocket, a covered call can limit your upside potential since you’re obligated to sell the stock at the strike price if the option is exercised.
- Those Averse to Selling Stock: If you’re sentimentally attached or believe in the long-term potential of the stock, a covered call strategy might not be ideal since there’s a possibility you’ll have to sell your shares.
Tax considerations can be complex, and they vary based on jurisdiction and individual circumstances. Here are some general observations:
- Premiums: The premium received from selling the covered call is typically considered short-term capital gain (or ordinary income) for tax purposes, regardless of how long you hold the option.
- Selling the Stock: If your call is exercised and you’re required to sell the stock, you’ll incur capital gains or losses based on the difference between your stock’s cost basis and the strike price. Depending on how long you’ve held the stock, this could be classified as a short-term or long-term capital gain or loss.
- Unexercised Options: If the option expires worthless, you keep the premium with no further obligation, but there’s no capital gain or loss on the stock itself unless you sell it.
It’s essential to consult with a tax professional or financial advisor to understand the specific tax implications for your situation and jurisdiction.
In summary, a covered call strategy is a tool for generating additional income and potentially realizing some capital appreciation on an underlying asset. However, like all investment strategies, it carries risks and benefits and should be understood thoroughly before being employed.
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Zack Swad, financial planner located in Santa Rosa, CA
Zack Swad is a fee-only financial planner located in Santa Rosa, CA serving clients locally and across the country (virtually).
He specializes in financial planning and retirement planning for people age 50+. As a fee-only, fiduciary, and independent financial advisor, Zack Swad is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice. He has been in the finance industry for over 11 years. He previously worked for a Fortune 500 Financial Services company, managing a practice of $800 million for 300 clients. Zack then went on to build his own firm, Swad Wealth Management, LLC so he could make a deeper impact in his client’s lives. In his free time, Zack enjoys spending time with his wife Elise, playing board games, piano, and singing.
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